The Allocator: Chris Ailman of California State Teachers' Retirement System

Read more:

Calstrs’ CIO discusses the market outlook, the search for the perfect manager and why the third largest pension in the U.S. is investing in hedge funds for the first time.

At $130 billion in assets, the California State Teachers'
Retirement System is the third largest pension in the United
States. But in terms of its approach to investing in hedge
funds, the pension lags far behind its peers.

The $199.4 billion California Public Employees' Retirement
System first started investing in hedge funds in 2002 and now
has $6 billion invested with the funds, while the $132 billion
New York State Common Retirement Fund made its first hedge fund
investment in 2005 and now allocates $3.8 billion to various
managers. By contrast, Calstrs has invested only 1% of its
assets in what it calls alternative strategies—and
that money is mostly invested in distressed strategies and
Treasury Inflation Protected Securities.

"Because we’re one of the largest funds that
hasn’t embraced hedge funds and drank the Kool
Aid, we get made fun of on the school block," Calstrs' chief
investment officer Christopher Ailman joked.

But that is about to change. In a world where markets are more
correlated than ever, diversification has become critical, and
Ailman’s believes hedge funds are the way to
achieve it. Calstrs is searching for a consultant to help it
select hedge funds and is evaluating a variety of strategies.
Ailman is particularly optimistic about global macro,
commodities, and funds invested in infrastructure.

In the near term, Calstrs will allocate $250 million in up to
five global macro funds, but the pension’s goal is
to increase its hedge fund allocations to 5% of total assets,
or $6.5 billion. Ailman is confident that if the hedge fund
investments generate consistent returns, that allocation will
only increase. "This is a marathon, not a sprint," he said. "In
a marathon you don’t win in the first mile or even
in the middle."

Ailman joined Calstrs in 2000. In addition to managing the
pension, he oversees seven directors and 96 investment
professionals. AR Staff Writer Suzy Waite caught up with
Ailman to discuss the market outlook, the search for the
perfect manager and why the third largest pension in the U.S.
is investing in hedge funds for the first time.

AR: Calstrs is entering hedge funds for the first time.
Why now?

We do have investments in distressed debt funds, of which some
could be categorized as hedge funds. We also have investments
in corporate governance activist funds.

With that as a backdrop, our interest in traditional hedge
funds is really coming from a broad review of different
strategies that we think could add value and diversification.
We think global macro looks particularly interesting.
We’re not going to invest in a mess of hedge
funds. We’re specifically looking at global macro,
both systematic and pure active, and this will be our first
allocation to global macro.

Why have you waited so long to seriously invest in
hedge funds?

Calstrs is a very education-focused fund. We obviously
represent school teachers in California, so the board is
comprised of people interested in education. We tend to study
things before we run out and invest in them. Our fund has a
history dating back 20 years of not wanting to start out with
newest idea out of Wall Street. We like to see how it performs
and see some track records.

I applaud some of the universities, particularly endowments,
that were early in global macro and did well.
We’re a large public fund with a different
liability scheme and a different structure.

We’ve also, for a period of time, avoided things
we view as too high cost. That’s partly why
we’ve been slow at looking at hedge funds. We view
them as business structures that are a high cost and put the
investor in a position of weakness or disadvantage to the
general partner.

If you think hedge funds are expensive, what are you
planning to do about fees?

Calstrs will negotiate the best fee structure we feel is both
fair for our partners and which maximizes long-term value for
our members.

How do plan to get started?

We’ll invest $250 million over the next nine
months in three to five managers. We recognize that
that’s a small allocation for us, but obviously
people are willing to talk with us because of our sheer size
and in the hopes that the allocation will grow.

It’s an opportunity to see how global macro
performs for us. If it adds value and reduces risk for the
fund, we’ll expand the program over time.

Why global macro? What opportunities do you hope to
exploit?

Clearly the lesson of the decade—not just 2008, but
the entire decade—was that there is more correlation
amongst equity markets, credit markets, stocks and bonds around
the world. Institutional investors are looking for more
diversification and a different return pattern.

We think global macro is a good strategy simply because it
should be able to not just add returns, but reduce risk by
increasing diversification.

What are some other strategies that you’re
considering?

We like the idea of inflation sensitivity, so our board
approved an investment in commodities. We’re
looking at all different types, not just managed futures.
We’re also doing research into micro finance and
will be allocating to infrastructure-focused funds.

I’ve always liked convertible arbitrage and
M&A arbitrage, but the spread has contracted as people
entered into those markets. Still, I think we’re
coming into an era where M&A arbitrage might be an
interesting place. We’re coming into a cycle with
private equity where we’ll see more acquisitions
and strategic mergers between companies and subsidiaries.

What is in the portfolio right now?

Fifty-four percent is in global equity (long only), 21% in
fixed income, 13% in private equity, 10% in real estate and 1%
each in absolute return and cash.

Our absolute return bucket is a bit of a misnomer.
It’s basically a bucket in which we put lots of
different types of assets. Most of that 1% is an inflation
sensitive portfolio, which is TIPS. Our allocation into global
macro and any hedge fund would land in the absolute return
portfolio.

You’ve said you would like to eventually
get to a 5% allocation in hedge funds. How long will that
take?

That’s where our sheer size comes into play.
Moving this portfolio around is like steering a huge cruise
ship. You don’t want to throw the wheel to one
side or another because you’ll disrupt everything.
You’ll also create a wake—e.g.,
transaction costs—which just is a drag on the
portfolio. It’s a challenge for a portfolio this
large to be nimble. That’s something we aspire to
be, though.

Will you invest in startups or more established
managers, such as those running $5 billion or
more?

If you look at our other asset categories, we very much believe
in a blend of long–term, established firms as well as
new firms.

That said, normally we talk to startups. We’re
very interested in them. Now we’re kind of on a
clinical trial, and we’re looking for a small
handful of funds with an existing track record that we can
really sink our teeth into.

We tend to find that with new firms, the people are very
hungry, very focused on alpha. Their name is on the door, they
have a lot at stake.

You’ve discussed the advantages to
investing with new firms. What are the disadvantages?

It’s challenging for a firm our size.
I’ve had that experience of being the majority of
someone’s assets under management. And if things
aren’t going well and you want to pull out,
you’re pretty much going to put them out of
business.

What are the disadvantages to investing with an
established manager?

A lot of times, a large chunk of the portfolio is their own
money and often, they want to invest your money on different
terms and conditions. Suddenly you’re secondary,
and that’s pretty clear, especially if
it’s a different pool of assets and not
commingled. You get a little worried about where the loyalty
lies, how they’ll allocate it, where will the best
idea go, and when they run to the exit, where will it go.

What we also find with bigger firms, and I call it the "CFO
syndrome," is when you get to be pretty big and you hire your
CFO, sometimes they talk with the traders, and the discussion
moves away from investment ideas and comes around revenue flow,
income levels, fee levels, and everyone becomes more benchmark
aware. We find that as a negative.

Some managers will come in and tout that they’re
benchmark aware. To me, that’s a big red flag.
That means they’re risk adverse and are just
trying to get a more stable revenue stream. I can get market
returns for almost free. What I am looking for is skill that is
repeatable over time.

You see these firms ebb and flow over culture, structure, and
sometimes the skill just leaves the building, even if
there’s no change of personnel. It becomes an
interesting challenge. Everybody talks about the people,
process and philosophy, but what we really focus on is the
culture. It’s the subtle changes in culture that
are very difficult to measure, but it’s the
culture of the office and the people that’s a
leading indicator.

What would cause you to redeem?

The simple and obvious signals are key departures and mergers
in the money management business.

But we look for the subtle changes within the dynamics. You can
only get that from being in the office. You can’t
get that from having the senior people visit you. And you
can’t get that from a one hour meeting in their
corner glass conference room. When I go to meet managers,
I’ll wander off and around the office. I encourage
my staff to do the same, and to sit in the office for several
hours working at one of their desks. In the first hour everyone
is on guard, but after that, you see how people deal with
things.

Are you planning on investing direct or going the funds
of funds route?

We’ll be going direct; we’re not
doing funds of funds. I view that as fees on fees.

I think one of the things we are skillful at is performing
extensive due diligence. We have a lot of good analytical tools
and we have the people to analyze firms and investment
processes to help us try and cull between people with luck and
people with skill.

What we’re looking for is sustainable performance.
Not a short term run or even a good cycle. We want reputable,
sustainable performance.

What are the disadvantages of funds of funds?

I know I’m a bit critical of them, but you have to
recognize the position we’re coming from as a very
large investor with a lot of resources. For a smaller shop or
fund, I could certainly understand going that direction and
getting that institutional help. You’re also
getting access to some of the best and brightest funds.

But it also gets back to our philosophy on hedge funds; which
is they are not just a bucket asset class. They are a bunch of
different investment strategies that fall under our existing
asset class structure. You’re either fixed income,
equity or asset allocation strategies, and so a fund of funds
in deploying all six broad categories doesn’t fit
that philosophy. We would rather take our equity team and look
at market neutral and long/short, or take our fixed income
group and look at convertible arbitrage and fixed income
arbitrage.

Traditional funds of funds don’t fit our
philosophy. We’ve been investing in private equity
for over 20 years and investing in real estate for almost two
decades. We’ve shown that we have some level of
skill in discerning between shops that have a solid investment
philosophy and have the right people and structure to succeed.

What strategies are you avoiding?

I wouldn’t say we’re avoiding
anything specific. We generally tried to avoid areas where
everyone else is rushing into. Sometimes the herd mentality is
wrong. We like investing in things that other people are
tending to move out of.

For example, lots of our peers have been reducing or
eliminating their currency active management strategy.
We’ve been adding to our currency overlay.

What are some areas that everyone else is rushing into
now?

It’s interesting now. I see people in a holding
pattern. I wouldn’t describe it as shell shocked
or frozen, I think they’re in a holding pattern.
It’s so uncertain where these markets globally
will head.

There are real, deep systematic issues plaguing Europe and the
U.S. and difficulties with the Japan market still.
It’s really tough to figure out. We all know the
BRIC story. It’s tough to figure out how the
global GDP will turn it out. Right now, sovereign debt is at
historic highs. That’s an area that’s
worrisome. Meanwhile, U.S. interest rates are at absolute
historic lows.

In the past year, high yield is still at historic ranges, but
they’ve made great returns recently. I
don’t know if that means you should put more money
there. It’s a very challenging market and very
tough for investors.